The courtroom was charged with emotional electricity. The reputation, not to mention freedom, of each participant was at stake. Tom Cruise's Lt. Daniel Kaffee, a previously glib but now earnestly committed Navy lawyer shouts, "I want the truth!" Jack Nicholson's Col. Nathan Jessep, a cold-hearted manipulator of men fires back from the witness stand, "You can't handle the truth!" It is the pivotal scene the 1992 movie A Few Good Men. It could just as easily be a conversation between an investor and his or her broker.

"The sad truth is that there are only three kinds of financial prognosticators: those who don't know, those who don't know they don't know, and those who know they don't know and get paid big bucks to pretend they know." - Burton Malkiel, Princeton University Professor of Economics and author of A Random Walk Down Wall Street.

We have spent the past three essays decrying the broken business model of investing defined by commission driven self-interest, wealth-stealing fee structures and suspect claims of market-beating expertise. I concluded our previous discussion with a promise of good news amidst the storm swept seas that ravage our voyage and impede our journey to Peaceful Wealth. It is a solution based on the wisdom of the market, and available to all with the courage to chart a new course.

The year was 1900. A French mathematician named Louis Bachelier wrote a Doctoral thesis titled "The Theory of Speculation". Bachelier's path blazing work used higher math to describe a seemingly random pricing of stocks within the market that provided no help to those trying to predict or profit from future price changes. He argued that markets are "an aggregate of speculators" who "at a given instant can believe in neither a market rise or a market fall, since, for each quoted price, there are as many buyers as sellers."

Bachelier's thesis offers a simple truth with profound implications that have been re-examined and re-confirmed under the lens of 100 years of academic research. Every stock transaction is an agreement between a seller who believes their most profitable course of action is ridding themselves of a given stock and a buyer who believes just the opposite. This competitive interplay translates all known and suspected information about the stock into a specific stock price. Changes in price occur when new information drives buyers and sellers to alter their assessment of the stock. Only new information and unpredictable swings in sentiment will result in a price change. The competitive forces of buying and selling demand all known (and/or predicted) information be incorporated into the price of the stock.

Active managers and stock pickers believe the market is broken, or at least has fissures available for profitable exploration, and somehow they are able to see what no one else can predict. They seek to exploit opportunity and covertly uncover value using methods and systems that give them an unfair advantage over the competition. As we presented in our last essay, active management has two flaws; it is expensive and it does not work.

How does embracing the fact markets accurately reflect all known information help investors stay on course? It is the foundation upon which you can reject the allure of active management. If no one can successfully predict future stock prices, there is no reason to waste your time and spend your money engaging those who claim otherwise. Turn off CNBC. Refrain from yelling "Booya" or being lured by the omnipresent financial pornography clamoring for your money as they attempt to sell the "10 stocks to make you rich this year!" or "3 hot sectors you must own today!" Rex Sinquefield, co-founder of Dimensional Fund Advisors and a pioneer in the pursuit of Peaceful Wealth, drolly observes "Today the only people who don't think markets work are the North Koreans, the Cubans and the stock pickers".

Managing risk has its rewards

The year was 1952. Harry Markowitz introduced the concepts of managing risk in the selection of a portfolio and the existence of an "efficient frontier" in his Doctoral thesis published in the Journal of Finance. His "efficient frontier" proposal theorized an optimal portfolio of stocks and bonds could be created to maximize investor returns for a desired level of risk. Risk is defined by the up and down swings in value every security experiences in a competitive market.

Markowitz' work, and the concepts of Modern Portfolio Theory it spawned, were a head-on assault to the conventional wisdom of the day. Listen to the words of Gerald Loeb in his 1935 book The Battle for Investment Survival, "Once you attain competency, diversification is undesirable. One or two, or at most three or four, securities should be bought. Competent investors will never be satisfied beating the averages by a few small percentage points". Sound familiar? Jim Cramer, former hedge fund manager and guru of Mad Money on CNBC, feasts daily on the principles Loeb espouses. While he may produce entertaining television (in a rather frenetic way), Mr. Cramer is just as wrong today as Gerald Loeb was in 1935.

Modern financial theory extends the early work of pioneers like Markowitz to identify factors within the market that allow investors to successfully invest in a portfolio with performance characteristics suitable for their individual objectives and comfort levels. A fundamental requirement for success in the market is to define the appropriate level of risk each investor is willing to endure in exchange for the total returns they seek. Understanding the efficient frontier, and utilizing the benefits it offers is critical to long-term investor success.

One common mistake investors (and the ignorant or uncaring brokers that advise them) make is to assume all risk is rewarded by the market. Inappropriate risk can destroy a portfolio. Weston Wellington, Vice-President at Dimensional Fund Advisors, says in his article Equilibrium-based Investing, "The accepted thinking among researchers is that markets reward only nondiversifiable risk." He continues, "The risk of holding any single stock is far greater than that of a diversified portfolio (it could be the next Google or the next Enron) but the expected return is no higher than that of the diversified portfolio, so the additional risk of holding a single stock is not rewarded by additional expected return. Investors should not expect a reward for risks that can be easily diversified away."

Common sense? Yes, but common sense is anything but common within the broken business model of investing. The story of Jim (not his real name) exemplifies the pain many clients are forced to endure. Jim was a company man, having served as a supervisor in the manufacturing department of a Fortune 500 consumer goods company. He spent over forty years, his entire adult career, doing all the right things. He worked hard, lived below his means and saved his money in anticipation of his eventual retirement. His efforts and ethics were rewarded when he retired with over $1 Million in company stock. He was set for life and looking forward to a long and enjoyable retirement adventure with the wife of his youth. Unfortunately for Jim, he was naïve. A cold call from a broker came just when he was trying to sort through his investment options. She worked for a global financial services company and promised him access to the best research and money management the firm could offer. Jim trusted her to care for his nest egg. She told him she would diversify the money among the best stocks of the day, achieving the twin benefits of enhanced return and reduced risk. What was her strategy? To invest Jim in 30 high-tech companies just prior to the bursting of the Internet bubble. Her plan did not work out too well for Jim. Jim came to me with a portfolio worth only $164,000. He was forced to go back to work (at significantly less pay) for a small manufacturing plant and is unsure if he will ever retire or fulfill the dreams that only a few years prior were tantalizingly attainable to him and his wife.

What are the rewards offered by the efficient frontier? Understanding how markets work and the risk vs. reward trade-offs help investors steer a direct course to their intended destination. It offers a benchmark to define success and an incentive to avoid unnecessary risks and potentially harmful strategies. It brings clarity in times of market fluctuations because investors recognize the link between short-term volatility and long-term reward. It also is a wonderful gauge to judge the value of any advisor offering assistance on your journey. Jim certainly wishes he and the broker he entrusted with his life savings understood the efficient frontier. He will never again make the same mistake. Nether should you.

We have only set two of the four sails required for our journey to Peaceful Wealth. We will define the principles of proper portfolio construction and the power and freedom found in knowing your time horizons next week.